Japanese Yen May Recover as Post-FOMC Selling Evolves into Risk Aversion

The 83rd annual report from the Bank of International Settlements (BIS) released over the weekend spoke out against central banks’ “whatever it takes” approach to monetary policy in the aftermath of the global financial crisis, warning the extraordinary accommodation of recent years has bought time for structural reforms but is not a substitute for them. With that in mind, it called on the private sector to hasten balance sheet repairs, on governments to redouble efforts to achieve fiscal sustainability, and on regulators to reform oversight and ensure banks are adequately capitalized.

Perhaps most ominously, the BIS argued that the cost-benefit balance to continuously aggressive monetary stimulus is “inexorably becoming less and less favorable.” In this context, it cautioned that postponing the inevitable exit from the current ultra-accommodative policy regime makes doing so progressively more challenging. The report specifically cited the dangers of an increase in interest rates for public finances in countries where the crutch of “cheap money” has delayed budget reforms, saying a mere 3 percent rise in US Treasury yields across the maturity spectrum could inflict losses of $1 trillion on bondholders (excluding the Fed).

Price action seen last week in the aftermath of the FOMC monetary policy announcement seems to validate the BIS’ concerns. Fed Chairman Ben Bernanke said policymakers can conceivably begin to reduce the size of monthly asset purchases this year, with eye to discontinue them by mid-2014. This sparked a sharp drop in US Treasuries, with the benchmark 10-year yield racing higher to finish the week at a two-year high of 2.58 percent. Broad-based liquidation of positions relying on cheap QE-linked funding likewise prompted selling of European, Australian, Canadian and New Zealand government bonds, boosting yields there as well.

Japanese bond yields mark a notable exception to the jump elsewhere in the major economies, with the 10-year JGB rate holding steady even as others soared. That’s not altogether surprising: the very low-yielding JGBs are unlikely to have been a major beneficiary of QE-driven capital inflows when compared to higher-paying alternatives elsewhere in the G10 space, so post-FOMC liquidation is probably not a significant factor. This may explain the persistence of Japanese Yen weakness both last week and in overnight trade as widening yield gaps encourage carry trade interest. As we discussed last week, this is among the key factors drawing a distinction between the post-FOMC carnage and outright risk aversion.

On balance, the BIS report underscores the danger that the reversal of the “Fed levitation” trade and the forthcoming withdrawal of stimulus in general may translate into a broader-based meltdown in risk sentiment. Indeed, confidence in the continuity of the global recovery may fizzle if the jump in borrowing costs compounds fears of a slowdown in China and lingering recession in the Eurozone. If this produces a true “flight to quality” collapse in risky asset prices, carry trades are likely to crumble as the desire for safety overwhelms yield considerations, sending the Yen higher.

June’s German IFOsurvey of business confidence headlines the economic calendar in European hours. Expectations call for a slight increase in the headline Business Climate index, putting it at three-month high of 105.9. Against a backdrop of worries about the withdrawal of central bank support, an improvement may prove to carry negative implications for risk trends and (somewhat counter-intuitively) weigh on the Euro against USD and JPY as bets on further ECB accommodation are reduced. The single currency may find better support against higher-yielding currencies in the commodity bloc as well as the British Pound.